The Intelligent Investor: Things to Consider About Per-Share Earnings

This is the thirteenth in a weekly series of articles providing a chapter-by-chapter in-depth “book club” reading of Benjamin Graham’s investing classic The Intelligent Investor. Warren Buffett describes this book: “I read the first edition of this book early in 1950, when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.” I’m reading from the 2003 HarperBusiness Essentials paperback edition. This entry covers the twelfth chapter, which is on pages 310 to 321, and the Jason Zweig commentary, on pages 322 to 329.

This version of The Intelligent Investor was written by Ben Graham in 1972, yet time and time again I am practically convinced that Ben is actually writing about today’s stock market.

It’s not so much that Graham is some sort of prophet. You can tell from some of the specific examples that he’s clearly writing from the perspective of thirty five years ago. He vastly overestimates the value of bonds, at least in terms of how people today would invest. His specific examples of dominant companies are rather laughable in today’s market – some are completely out of business, while others are shells of their former selves.

What’s amazing about Graham’s writing is that he really understands the basic principles that underline all of this stuff – and those principles are largely still true. Then, as now, greedy businesspeople will try to cook the books. Then, as now, investors have something of a herd mentality and will overlook some serious values if that’s not where the herd is. Then, as now, salesmen and charlatans pose as legitimate investment advisors, peddling dubious advice and collecting kickbacks all along the way.

It’s because of Graham’s deep understanding of this that The Intelligent Investor is still such a valuable book. Gloss over the specifics and look at the principles. You’ll find that they’re incredibly accurate.

If a thirty-five year old book can be so prescient, one can’t help but wonder what value all of the modern information flood has when it comes to investing.

Chapter 12 – Things to Consider About Per-Share Earnings
This is actually a pretty short chapter. Graham really only has two major points to discuss about per-share earnings – the amount of money a company earns on paper for every single share of their stock.

First, don’t take a single year’s earnings seriously. There are many, many reasons why a company’s single-year earnings can be completely out of whack with the true reality of the health of a company. For example, many of the companies affected by the subprime lending crisis had extremely anomalous single years for 2008 in terms of earnings because they wrote down those losses all at once. Similarly, a company can have very nice returns in a single year thanks to a short-term effect – a big fad or something like that.

What should you do instead? You should look at earnings over as many years as you possibly can and attempt to get a real bead on the direction the company is going over the long term. A single year is not enough to accurately judge the direction of the company.

That leads directly into Graham’s second principle, if you do pay attention to short term earnings, look out for booby traps in the per-share figures. In other words, if a number looks too good to be true, it probably is.

What can you do here? If you use that short-term number for anything important, you need to do some serious research into the stock. Read the annual report. Read the SEC filings. Dig into the details of what is actually included in the earnings number being used here. What’s being included in it? Are there “one time charges” all over the place? What are those charges, and how would the number change without those charges?

What’s the real lesson that Graham is teaching? There is no single number that you can use to really evaluate a stock or a company. There are so many tricks that a company can use to manipulate their numbers, both legitimately and otherwise, that relying on a single number to judge a company is a fool’s game. You’re begging for a company to trick you if you rely on minimal information.

Commentary on Chapter 12
Zweig spends his commentary arguing that Graham’s principles on per-share earnings are actually more true today than ever before, and he uses the chicanery of the past decade to make his case. Enron. Adelphia. WorldCom. Global Crossing. These companies looked great on paper if you took an extremely superficial view, but if you started digging into the data, it started to look a little more shaky. And, of course, we know what happened over the long run.

Zweig offers a few general principles for today’s world.

First, read financial reports in reverse. Often, the nastiest stuff a company has to report is hidden in the back in footnotes. When you want to know how a company is doing, start digging in there to get the real story.

Next, read all notes. If you see a number in a financial report followed by a comment like “see Note 1” … immediately read Note 1. It’s usually an indication that the number you see there has been cooked in some fashion.

Finally, read more. If you’re actually going to get into individual investing to the point that you’re devouring financial reports, know how to read them. Get geared up on basic accounting principles. Read books on financial statement analysis (Zweig recommends Financial Statement Analysis by Fridson and Alvarez).

All around, it’s good advice. Never trust a single number, and never trust that the company is going to make the skeletons in their closet immediately clear to you.

Next Friday, we’ll take a look at Chapter 13: A Comparison of Four Listed Companies.

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